European Debt Crisis: Are You In or Out?

Forget about core and peripheral countries.

The European debt crisis has been one long slow-motion train wreck. On Monday, Martin Wolf, the chief economics commentator at The Financial Times, suggested that a breakup of the eurozone now looks possible. Even if the eurozone remains intact, the crisis will almost certainly continue to drive money back and forth as global equity markets alternately race into and out of risky investments. That's particularly true for the source of huge risk -- and opportunity -- at the crisis's heart: the banking sector.

The risk: eurozone banksThe euro crisis could disrupt the European banking system and financial markets far more than the fall of Lehman did in the United States. At least in that case, the U.S. government and the Federal Reserve reacted quickly and forcefully to a fluid crisis situation. But the European Union is built on bureaucracy and lengthy consensus-building; in many cases, individual countries have veto rights. It's difficult to think of an organization less suited to crisis management, and there is no established mechanism for a country to leave the eurozone. It would be fantasy to expect any exit to occur in an orderly manner.

Too many cooks are spoiling this bailout, with 17 national governments and central banks, the European Central Bank, the European Union ,and the International Monetary Fund all vying to have their say. Amid that kind of cacophony, it's not surprising investors are spooked.

Who's the basket case here?The resulting confusion has produced some seemingly paradoxical situations -- and the potential for substantial mispricings. It's rather odd that the largest banks in France and Germany, the two pillars of the eurozone, should trade on lower book value multiples than those of Spain:

Company

Country

Price-to-Tangible Book Value Multiple

Banco Bilbao Vizcaya Argentaria(NYSE: BBVA)

Spain

0.99

Banco Santander(NYSE: STD)

Spain

0.82

Deutsche Bank(NYSE: DB)

Germany

0.62

BNP Paribas

France

0.51

Commerzbank

Germany

0.38

Societe Generale

France

0.33

The opportunity: non-eurozone European banksWithin the eurozone, the distinctions between core country banks and those in peripheral countries -- the so-called PIIGS of Portugal, Italy, Ireland, Greece and Spain -- have become blurred. However, countries' place inside or outside the eurozone remains a critical distinction. Western European EU members that haven't adopted the euro include Sweden, Denmark, and the U.K., not to mention the highly developed banking sector in Switzerland. The banks in these non-euro countries have much lower risk, and some of them look attractive.

One of Sweden's top four lenders, Swedbank, earned a 12.5% return on its common equity. It's also well-capitalized, with a Core Tier 1 Capital ratio of nearly 15%. Despite this, the shares change hands at roughly their tangible book value, and less than five times the forward earnings estimate. For reference, JPMorgan Chase(NYSE: JPM), which also trades near its tangible book value, only mustered an 11.4% return with higher leverage (its Core Tier 1 ratio is 10.1%). Core Tier 1 Capital is the highest-quality capital; on that basis, Swedbank's balance sheet is leveraged less than seven times, whereas JPMorgan's is leveraged 10 times.

UBS(NYSE: UBS) shares also trade near their tangible book value. Their latest multibillion-dollar loss due to a rogue trader bolsters my opinion that UBS should hive off its investment banking activity. That monster is a hybrid offspring of numerous acquisitions, which collectively has never inspired confidence in its ability to manage risk. Sell the investment banking unit, and management will be free to focus their energies on the three very profitable remaining businesses: private wealth management, asset management, and Swiss banking. Those businesses ought to command a real premium over book value.

Be warnedI want to give readers fair warning: Unless you're experienced, knowledgeable, and dedicated, stock picking is best left to the professionals. That is doubly true when it comes to picking bank stocks. And whether professional or amateur, investors can't know every detail of a bank's loan or securities portfolio, or the risk and severity of a potential liquidity crisis. As such, investors venturing into this arena need to be familiar with the notion of "risk capital," and comfortable with stomach-churning volatility.

Greater volatility and greater opportunityWe have not seen the worst of this crisis. Things will get worse for the banks in the eye of the storm. However, outside the eurozone, the opportunities to buy profitable, well-capitalized institutions will only become more attractive. There is no need to rush in, but I do recommend that experienced investors begin tracking banks like UBS by adding them to your Watchlist.